The Financial Services Authority said Hastings Direct - which uses the 1066 number in its enquiry line - had failed to treat its customers fairly when it cancelling 4,550 policies after discovering they had been under-priced.

The problems occurred between July and September last year. Software problems meant that some customers were offered significantly lower premiums - in some cases by as much as £539.

A spokesman for the FSA said that the insurer "focused on the financial cost to itself and did not properly consider the detrimental effect on customers", many of whom had to arrange alternative cover at short notice. There was also a risk that with little notice some policyholders may have been left uninsured while the re-arranged cover.

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The FSA said some customers may have had to pay higher premiums as they were obliged to declare that their last policy was cancelled.

Hastings is now contacting all customers affected, informing them that they could be entitled to compensation. Only those who complained about stress and inconvenience were previously offered any payment.

After FSA investigation Hastings also uncovered 150 cases of mis-selling where ancillary products were offered to customers when re-broking their cancelled policies.

The FSA added that the fine would have been more than £1m if Hastings had not agreed to settle the case at an early stage.

A spokesman for Hasting Direct said: "Whilst Hasting does not consider the use of a cancellation clause is of itself unfair, it does accept that in this instance these particular processes and procedures could have been better and has acted quickly to rectify them.

"The company has taken substantial remedial action in relation to its systems and management."

Hastings Direct was created in 1997 by David Gundlach, who helped launch Admiral Insurance.

Contrary to an earlier version of this article, Hastings Direct is now part of IAG insurance and not AIG as was stated. We are happy to make this clear.